Download Short-Term Finance and Planning

19
Short-Term
Finance and
Planning
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Understand the components of the
cash cycle and why it is important
 Understand the pros and cons of the
various short-term financing policies
 Be able to prepare a cash budget
 Understand the various options for
short-term financing
19-1
Chapter Outline
 Tracing Cash and Net Working Capital
 The Operating Cycle and the Cash Cycle
 Some Aspects of Short-Term Financial
Policy
 The Cash Budget
 Short-Term Borrowing
 A Short-Term Financial Plan
19-2
Sources and Uses of Cash
 Balance sheet identity (rearranged)
 NWC + fixed assets = long-term debt + equity
 NWC = cash + other CA – CL
 Cash = long-term debt + equity + CL – CA other than
cash – fixed assets
 Sources
 Increasing long-term debt, equity, or current liabilities
 Decreasing current assets other than cash, or fixed
assets
 Uses
 Decreasing long-term debt, equity, or current
liabilities
 Increasing current assets other than cash, or fixed
assets
19-3
The Operating Cycle
 Operating cycle – time between
purchasing the inventory and collecting
the cash from sale of the inventory
 Inventory period – time required to
purchase and sell the inventory
 Accounts receivable period – time
required to collect on credit sales
 Operating cycle = inventory period +
accounts receivable period
19-4
Cash Cycle
 Cash cycle
 Amount of time we finance our inventory
 Difference between when we receive cash
from the sale and when we have to pay for
the inventory
 Accounts payable period – time between
purchase of inventory and payment for
the inventory
 Cash cycle = Operating cycle – accounts
payable period
19-5
Figure 19.1
19-6
Example Information
 Inventory:
 Beginning = 200,000
 Ending = 300,000
 Accounts Receivable:
 Beginning = 160,000
 Ending = 200,000
 Accounts Payable:
 Beginning = 75,000
 Ending = 100,000
 Net sales = 1,150,000
 Cost of Goods sold = 820,000
19-7
Example – Operating Cycle
 Inventory period
 Average inventory = (200,000+300,000)/2 = 250,000
 Inventory turnover = 820,000 / 250,000 = 3.28 times
 Inventory period = 365 / 3.28 = 111 days
 Receivables period
 Average receivables = (160,000+200,000)/2 =
180,000
 Receivables turnover = 1,150,000 / 180,000 = 6.39
times
 Receivables period = 365 / 6.39 = 57 days
 Operating cycle = 111 + 57 = 168 days
19-8
Example – Cash Cycle
 Payables Period
 Average payables = (75,000+100,000)/2 = 87,500
 Payables turnover = 820,000 / 87,500 = 9.37 times
 Payables period = 365 / 9.37 = 39 days
 Cash Cycle = 168 – 39 = 129 days
 We have to finance our inventory for 129 days
 If we want to reduce our financing needs, we
need to look carefully at our receivables and
inventory periods – they both seem extensive
19-9
Short-Term Financial Policy
 Size of investments in current assets
 Flexible (conservative) policy – maintain a
high ratio of current assets to sales
 Restrictive (aggressive) policy – maintain a
low ratio of current assets to sales
 Financing of current assets
 Flexible (conservative) policy – less shortterm debt and more long-term debt
 Restrictive (aggressive) policy – more shortterm debt and less long-term debt
19-10
Carrying vs. Shortage Costs
 Managing short-term assets involves a
trade-off between carrying costs and
shortage costs
 Carrying costs – increase with increased
levels of current assets, the costs to store
and finance the assets
 Shortage costs – decrease with increased
levels of current assets
 Trading or order costs
 Costs related to safety reserves, i.e., lost sales and
customers, and production stoppages
19-11
Temporary vs. Permanent Assets
 Temporary current assets
 Sales or required inventory build-up may be seasonal
 Additional current assets are needed during the “peak”
time
 The level of current assets will decrease as sales
occur
 Permanent current assets
 Firms generally need to carry a minimum level of
current assets at all times
 These assets are considered “permanent” because
the level is constant, not because the assets aren’t
sold
19-12
Figure 19.4
19-13
Choosing the Best Policy
 Cash reserves
 High cash reserves mean that firms will be less likely to
experience financial distress and are better able to handle
emergencies or take advantage of unexpected opportunities
 Cash and marketable securities earn a lower return and are
zero NPV investments
 Maturity hedging
 Try to match financing maturities with asset maturities
 Finance temporary current assets with short-term debt
 Finance permanent current assets and fixed assets with longterm debt and equity
 Interest Rates
 Short-term rates are normally lower than long-term rates, so it
may be cheaper to finance with short-term debt
 Firms can get into trouble if rates increase quickly or if it begins
to have difficulty making payments – may not be able to
refinance the short-term loans
 Have to consider all these factors and determine a
compromise policy that fits the needs of the firm
19-14
Figure 19.6
19-15
Short-Term Borrowing
 Unsecured Loans




Line of credit
Committed vs. noncommitted
Revolving credit arrangement
Letter of credit
 Secured Loans
 Accounts receivable financing


Assigning
Factoring
 Inventory loans



Blanket inventory lien
Trust receipt
Field warehouse financing
 Commercial Paper
 Trade Credit
19-16
Example: Compensating Balance
 We have a $500,000 line of credit with a
15% compensating balance requirement.
The quoted interest rate is 9%. We need to
borrow $150,000 for inventory for one year.
 How much do we need to borrow? The
required amount plus the compensating
balance:
 150,000/(1-.15) = 176,471
 What interest rate are we effectively paying?
 Interest amount = 176,471(.09) = 15,882
 Effective rate = 15,882/150,000 = .1059 or 10.59%
19-17
Example: Factoring
 Last year your company had average
accounts receivable of $2 million. Credit
sales were $24 million. You factor
receivables by discounting them 2%.
What is the effective rate of interest?
 Receivables turnover = 24/2 = 12 times
 APR = 12(.02/.98) = .2449 or 24.49%
 EAR = (1+.02/.98)12 – 1 = .2743 or 27.43%
19-18
Quick Quiz
 How do you compute the operating cycle
and the cash cycle?
 What are the differences between a
flexible short-term financing policy and a
restrictive one? What are the pros and
cons of each?
 What are the key components of a cash
budget?
 What are the major forms of short-term
borrowing?
19-19
Comprehensive Problem
 With a quoted interest rate of 5%, and a
10% compensating balance, what is the
effective rate of interest (use a $200,000
loan proceed amount)?
 With average accounts receivable of $5
million, and credit sales of $24 million,
you factor receivables by discounting
them 2%. What is the effective rate of
interest?
19-20